Regular readers know I have very serious reservations about the rampant proliferation of ETFs.
In some instances (HY products) I can put my finger on exactly why (no liquidity for the underlying assets, a quarter of the float being used by institutions for daily liquidity needs, etc.), and in some instances (equity ETFs) I can’t quite get there.
But what I do know is that if you step back from the unit creation/destruction process (which generally seems to be functioning well) and just abstract yourself a bit, this just seems like a bad idea.
After all, ETFs are kind of, sort of derivatives. Now there’s a vociferous debate about that and I’m really – really – inclined to say it’s just semantics. Because at the end of the day, you’re buying something that represents something else even if it is, in a way, also a manifestation of that thing it represents.
Now we’ve got a situation where everyone is turning increasingly to passive, low-cost vehicles and indeed, hedge funds are throwing in the proverbial towel when it comes to beating benchmarks, going the least short equity ETFs on record in Q4:
(BofAML)
As I noted on Tuesday night, this ETF-dominated market environment was stress tested on the morning of August 24, 2015 and it failed miserably.
So at the end of the day, I’m not an ETF sponsor nor am I an AP, but I can’t help but wonder if this isn’t going to end up breaking down one day and the following excerpts from a new Deutsche Bank report (that most certainly wasn’t written in any kind of negative context) don’t do much to allay those fears…
Via Deutsche Bank
Institutional ETF assets grew by $213bn and reached $1.44 trillion in 2016 As of the end of 2016, almost 3,500 institutional investors held more than $1.44 trillion in ETF assets accounting for about 59% of all ETF assets. Investment Adviser remained as the dominant group with $813bn representing 33% of all ETF assets. Meanwhile, Private Bank/Wealth Management followed in a strong second place with $372bn in ETF assets or 15% of total assets.
Hedge funds recorded the strongest relative YoY growth in ETF assets Hedge funds saw an increase of 77% in ETF assets to $43.8bn, an increase from 1.2% to 1.8% in ETF ownership, and an increase of 17% in the number of funds using ETFs. Overall, they continued to prefer a reduced sample of ultra liquid ETFs. And had a very sizeable allocation to US Financials at the end of the year.
As per historical growth trends, ETF assets held by institutions and the number of products used by them have both grown more than 7 and 8 times in the last 10 years, respectively. Similarly, the number of different institutional investors using ETFs has almost double during the same period.
ETFs can be traded immediately like a stock while their out of favor predecessor Mutual Funds cannot. Does that imply less intraday liquidity such that a bad day could become a very bad day?
“ETFs can be traded immediately like a stock”… well see therein lies the problem. you’ve got ETFs trading without the underlying trading. so the conceptual question is always going to be what happens when the underlying is going crazy. and on August 24, 2015, I would contend we got the answer.
I tend to agree, especially if the underlying goes crazy. In the case of equity ETFs, my gut feel is that in the event of a large broad correction and with liquidity drying up, there will be a lot of pressure on market makers to stop a collapse. For me the question is would they be able to prevent it?
Wonderful. I read “Investing in ETFs (for Dummies)” today, under sunny spring skies, but remembered seeing something in your posts on Seeking Alpha about ETFs. Having wandered back, and read through your posts, and links therefrom, all I have to say is, “Holy Schnikeys!”. Thank you. I’ll try to disconnect from the secondary market and reconnect to the underlying securities Monday. Or maybe just the former…